Adopting inflation targeting in Albania Bank of Albania July, 2004

Overview What is inflation targeting? Problems of alternative regimes Preconditions Problems Decision Making Technical issues

Inflation targeting Inflation targeting was initially adopted by New Zealand in 1990, followed by many industrialised countries, and lately by developing countries. Until now, none of the countries that adopted the IT regime has not given it up.

What is inflation targeting regime? 1. Making public a numerical, mid-term inflation target 2. Institutional commitment to price stability as the main objective of monetary policy, and all the other objectives depending on it 3. An overwhelming information strategy, where many variables, not only monetary aggregates or exchange rate, are taken in consideration in order to decide on changing monetary policy instruments 4. High transparency of the monetary policy strategy by communicating to the public and the market plans, objectives and decisions of monetary authorities 5. Increasing the central bank’s accountability in meeting inflation targets.

Problems of alternative regimes Targeting monetary aggregates Requires a high correlation that can be forecasted between the selected aggregate and prices Money demand has reflected a high volatility and frequent structural changes A very unstable relation between money supply and monetary policy objective (inflation level) Not easily understood by the public

Problems of alternative regimes Fixing the exchange rate: The central bank looses the independent control on monetary policy Fewer possibilities to respond to internal and external shocks Stimulators of “dollarisation” of liabilities are generated Potentially dangerous because it can emerge from financial and banking system crises, with negative impacts on production

Advantages of inflation targeting An effective regime in reducing volatility in economy and ensure price stability by increasing credibility and accountability Makes decision-makers focus on long-term solutions Allows monetary policy to focus on internal problems and demand shocks Easily understood by the public, enhancing thus responsibility and transparency An effective mode to manage and reduce inflation

Preconditions When is adopted inflation targeting? Moving from a fix to a flexible exchange rate Concerns on inflation expectations Need to peg expectations and guide monetary policy decisions

Preconditions Independence of the central bank? - De facto or de jure? - In objectives or instruments? - The latest trends in the world (independence and objectives) Lack of fiscal domination - The central bank is not conditioned by the need to finance the government’s budget - Debt and risks of non-continuance of policy in the future:Would the central bank hesitate to tighten monetary policy for fiscal reasons, although it would be forced to do such a thing to keep inflation? Implications of the financial sector conditions

Preconditions Effective instrument monetary policy Relatively stable relation with inflation Use of indirect instruments of monetary control Usually, a short-term interest rate

Preconditions Transparency and accountability Need to have the public understanding inflation targeting Publication of Inflation report Publication of Monetary Policy Committee minutes (Supervisory Council minutes) Presentation of the central banks’ governing unit members before parliamentary committees

Inflation report Inflation reports are an important element in insuring transparency and accountability.They should include: An analysis of the current situation A forecast of the inflation rate (including insecurity), forecasts and suppositions on macroeconomic variables, and also an explanation on the way they are combined An explanation of the monetary policy conducted

IT pitfalls Flexibility versus credibility The more flexible the framework, the less credible Too much rigidity might lead to unnecessarily to a big difference in output Coexistence of multiple pegs is very probable to become a source of conflicts in policies, wchi can harm credibility Win credibility first in order to increase chances of having greater flexibility later

Decision-making Inflation targeting involves judgment Economic models can be only an input in decision-making, especially for developing countries Survey of relevant data in building up an opinion on inflation

Technical issues Setting a credible inflation targeting - An appropriate price index as an indication of inflation targeting - The hub for policy purposes (core index versus the already available indexes) - Inflation target: point, band, mid-term average? - Deadline of meeting the target

Inflation level Greenspan definition: An inflation rate so low that consumers and businesses do not take in consideration in their daily decisions Any inflation level between 0 and 3 per cent meets this criteria

Technical issues Understanding the transmission mechanism of monetary policy Role of short-term interest rates (intraday facilities) in interbank market – a policy instrument Role of assets price, expectations, credit or monetary aggregates, salaries and incomes Main shocks that have characteristically affected the aggregate demand and inflation